If you would like to understand the meaning of inflation and what causes it, click here before you continue reading this post.
Now that you know what inflation is, we are going to discuss it in depth.
Inflation is the rate of change of prices of goods and services.
Inflation is usually expressed in terms of the Consumer Price Index (CPI)* as shown in the graph below.
Inflation is often mentioned in a negative light but, contrary to popular belief, it is not always bad for the economy. In fact, inflation is needed to stimulate economic growth.
The Good Side of Inflation
Inflation makes consumers expect prices to continue to rise. Thus, people will buy now rather than later. This in turn increases demand in the short run. Stores then sell more and require more materials and hire more workers to meet the demand, increasing the cost of production, which then increase prices. It becomes a self-fulfilling cycle.
This is how inflation stimulates economic growth.
The Bad Side of Inflation
Inflation is undesirable if it becomes too high (or above the preferred rate of inflation of 2%).
High prices erodes the competitiveness of a country’s exports. Just imagine Singapore importing rice mainly from Thailand. Let’s say Thailand now has an inflation rate of 4% where as Indonesia has an inflation rate of 2.5%, it only makes sense for Singapore to import rice from Indonesia instead. In this case, Thailand has lost its competitiveness.
When prices are higher than they used to be, for the consumers, the value of a dollar now drops. This means that with $1, you can now buy less than you were able to.
In investment, inflation lowers the real returns.
Real Rate of Return = Nominal Return – Inflation
* New Vocabulary
CPI is defined as the change in the prices of a basket of goods and services that are typically purchased by specific groups of households.